BAML: Global markets are 'starting to get a little stretched' -- here's how we're guarding against a downturn

Markets are “starting to get a little stretched” as they grind higher, says James Barty, the head of global cross-asset and European equity strategy at Bank of America Merrill Lynch.

With US stocks already up 6% this year, Barty’s team has moved the options positions they are using to protect against a sell-off to higher strike prices.

Stocks could have another double-digit gain this year, thanks to earnings and economic growth, he said.

Markets everywhere are “starting to get a little stretched,” according to Bank of America Merrill Lynch.

Considering the data he references, that may come across as an understatement from James Barty, an investment strategist at the firm, whose Thursday note also explained how the firm is guarding against a sell-off.

“While we remain bullish for the year as a whole this is beginning to look a little too frothy for our liking,” Barty said.

The S&P 500 is already up 6% this year, as investors continue to expect earnings growth, benefits from tax cuts, and a strong global economy. The index’s Relative Strength Index, which measures the size and speed of its price movements and indicates whether it’s overbought, is at a post-war high.

Bank of America Merrill Lynch

For some perspective, Barty estimated that if the stock market continued to rally at this pace, the S&P 500 would top 7,000 by the end of the year.

BAML has chosen to hedge with options puts that could benefit from a market drop: buying March 2018 2x 2,750 strike puts, and selling puts set to expire in 2018 with an exercise price of 2,500.

To illustrate how fast the market has moved, Barty said the firm had bought put options with a strike price of 2,300. “We rolled this up last month to 2600 but that now requires a 9% correction to be in the money,” Barty said. The S&P 500 opened at 2,846.24 on Thursday.

Another way investors can protect against a sell-off is to simply take some money out of the market. The danger there is that timing the market is incredibly difficult. And, the biggest gains in a bull market are often found closer to its end than its beginning.

Investors could also bet that volatility would return to the market. However, this would be a “less interesting” hedge, Barty said, since it won’t pay off unless the market’s drop is more severe than a brief correction.

Although Barty is concerned about the risks of a correction, he maintains that higher company profits and economic growth could earn the S&P 500 a 12% gain this year. On Monday, BAML’s equity strategists raised their year-end target to 3,000 after the market zoomed past their previous target of 2,800.

“In short while we are concerned short term about the risk of a correction in markets or at least the need for a consolidation of recent gains, we remain constructive on risk assets for 2018 as a whole,” Barty said.